Anti-Fed Coalition Is Bound To Crack Up

John Carney

Aug. 21, 2009, 9:29 AM

It's been a very good couple of years for critics of the Federal Reserve. The central bank's role in creating the housing bubble, the dramatic expansion of its role in the economy and its nimble ability to grow its power despite its failings--failing upward, as they way--have all fed the case against the Fed.

Critics of the Fed tend to come in three flavors. There are the long-standing critics, mostly those engaged in Austrian economics in way way or another, who maintain that the Fed will inevitably create boom-bust cycles and that sane monetary policy directed by a central bank is a practical impossibility. There are the more recent vintage critics--those who tend to blame Alan Greenspan for holding interest rates "too low, too long" following the dot com bust and the September 11th attacks. And then there are the latest critics, who are distressed at all the newly discovered powers the Fed is implementing.

But the apparent alliance of these critics may falter on a crucial proposal put forth by the Obama administration. Under the proposal, lending by the Federal Reserve under Section 13(3) of the Federal Reserve Act--which authorizes the Fed in "unusual and exigent circumstances" to lend to "any individual, partnership, or corporation," against "notes" that are "secured to the satisfaction of the Federal Reserve Bank"--would be subject to the consent of the US Treasury.

The idea behind this is to "reign in" the Federal Reserve. Its proponents argue that the Fed is currently unchecked by the democratic process. This means the Fed can put taxpayer dollars at risk, since any insolvency at the Fed would have to be covered by taxpayers and government borrowing. To put it differently, if enough Fed loans went bad that it couldn't cover its own obligations, the US government would have to stand behind the Fed. If that reminds you of Fannie Mae and Freddie Mac, congratulations: you deserve a gold star for attentiveness.

The idea of the US government having to bail out the Fed boggles the mind, since currently the Fed is bailing out the US government by manipulating the Treasuries markets and lending to banks partially owned by the US government. A snake might be able to eat its own tail--but can it really eat its own head?

But giving the Treasury further authority over the Fed is unlikely to reign in anything. If anything, the Fed is already too compromised by its involvement in politics and the bailout of the banks. Drawing the Fed closer to the Treasury is not likely to result in sounder monetary policies but policies more likely to be subject to capture by special interests. We'll inevitably see log-rolling we see in the legislative branches, where one policy is permitted in exchange for undertaking another. The Fed gets to bail out banks so long as it also bails out car makers, for instance.

And this is where the anti-Fed coalition will fall apart. Those long-standing critics of the Fed want to see it abolished while the newer critics want to see it controlled. If the Controllers win, the Abolishers will discover that they have helped bring about a Fed that is far worse than the one they set out to destroy.

A far wiser tactic might be for the Austrian-Abolisher types to hold their nose and support those who are attempting to defend the independence of the Fed. Once they've vanquished those who would bring the Fed under control of the US Treasury, they can turn their guns against the Fed's existence. If that is too much to ask, at the very least the Abolishers should fight with equal vigor against the Dependent Fed as the Independent Fed. Whatever happens, they should avoid making common cause with the Controllers.

One sensible proposal that could actually reign in the Fed is put forth by Columbia Business School dean Glen Hubbard, Harvard Law professor Hal Scott, and John Thorton of the Brookings Institute today in the Financial Times. Their answer is rather simple: rather than allowing the Fed to exercise expanded powers with Treasury permission, just ban the Fed from certain types of lending.

Quite apart from the legal issue, the Fed's assumption of credit risk by lending against insufficient collateral could compromise its independence by: making it more dependent on the Treasury for support in the conduct of monetary policy, as illustrated by the supplemental finance facility; jeopardising the Fed's ability to finance its own operations and thus require it to seek budgetary support from the government; tarnishing its financial credibility in the event that it incurred big losses; and generally making it more subject to political pressures.

Based on these concerns, the Committee on Capital Markets Regulation has recommended that any existing Fed loans to the private sector that are insufficiently collateralised should be transferred to the federal balance sheet. While the Fed cannot go bankrupt, any Fed losses are ultimately borne by US taxpayers and should be directly and transparently accounted for as part of the federal budget. For the same reason, in the future, only the Treasury should engage in insufficiently collateralised lending.

But rather than reinforcing the Fed's independence, as our proposal would do, the Obama administration's reform proposal recommends amending Section 13(3) to require the written approval of the secretary of the Treasury for any emergency extension of credit. This would be a startling expansion of Treasury power over the Fed's use of liquidity facilities in classic lender of last resort situations - that is, where there was adequate collateral. Instead, the lines of authority should be clear. The Fed should have strengthened authority to loan against adequate collateral in an emergency. And the Fed should have no authority, even with the approval of the Treasury, to lend against insufficient collateral.

The Fed needs authority to lend in a crisis to avoid the chain reaction of failures of financial institutions, which could result in a complete economic collapse. However, this reason to act should not jeopardise the Fed's credibility and independence. Instead, these goals can be achieved by giving the Fed full authority to lend against good collateral - a traditional power of a central bank - while requiring bail-outs to be undertaken by the government. This change will enhance both the Fed's credibility and its independence and make our government more accountable.